The risks are now more “two-sided”…Fed still wins with S&P 500 rally, as the -30% loss in “real terms” is staggering…
Stocks have continued to strengthen, and in our view, this is more than just a “dead cat bounce” (aka bear rally) as we have outlined in multiple prior reports. But even if this proves to be a “bear rally,” the ingredients are in place for a rally far stronger than the “June pivot hopes” rally, which lasted 23 trading days and rose +16%.
- for much of 2022, it seems like the market’s perception of risk was one-sided
- consensus seemed to expect S&P 500 to fall easily below 3,200
- risks to inflation were higher, thus, Fed even tighter, and thus, risk assets fall
- but there is a notable shift in how markets see risk today
- it is more two sided
- as inflationary pressures are easing (see our recent reports and we discuss more on Fri)
- Fed also shifting towards a more measured/ data dependent approach vs +75bp each meeting
- market positioning far more risk-off
- price action has improved
In our view, these are the supports for a more durable rise:
- Fed is explicitly discussing a “pause” (even 3 most hawkish members) as growing recognition that the rate hikes take time to realize effects.
- Today’s collapse in home prices furthers this argument. Decline in Case-Shiller in August was -0.7%, the largest ever monthly decline. This is AUGUST data. We are in late October. Housing has gotten FAR WORSE since then. August. Thus, more reasons for Fed to consider “pausing”
- Investors are underestimating “fair value” P/E for S&P 500 as many clients tell us P/E needs to contract because interest rates are up. In short, many see P/E 14X-15X at a 4% 10-year.
- That is just not consistent with history.
- Since 1930, when 10-yr is +/- 4% median P/E is 19X. And when Fed is tightening, at 4% 10-yr, median P/E is 18.5X. Thus, P/E should be expanding from 16X currently.
- 2023 Street consensus EPS is $238 and at 18.5X is S&P 500 4,400. This is >16% from current levels.
- Stocks are not priced for perfection.
- Additionally, the S&P 500 is down -20% in nominal terms, but down -28% on “real terms” (CPI adjusted). The Fed has won. Stocks have been obliterated.
- But this also means a 50% rally in equities would still leave stocks -15% on a “real basis” — in other words, S&P 500 4,500 would still be consistent with Fed’s goals of tightening financial conditions.
- Fundamental data needs to be supportive as well. The main issue is to see inflation cool from 8% currently. This seems underway for reasons we have previously discussed.
NOT PRICED FOR PERFECTION: Since 1930, when Fed tightening, P/E 18.5X when US 10-yr between 3.5% to 4.5%
We believe investors are overly pessimistic on P/E ratios when 10-yr interest rates stay at 4% to 5%.
- rates can stay “higher for longer” so P/E could be pinned there
- many investors believe P/E could fall to 15X or less
- history does not support this
- take a look below
- since 1930, when UST 10-yr is 3.5% to 5.5%, P/E historically the highest
- even during Fed tightening cycles (see solid blue line)
LOOK PRIOR TO DOT-COM: High P/Es when interest rates at these levels
In case one thinks we are only looking at dot-com valuations. That is not correct. Our data science team, led by tireless Ken, has plotted all tightening cycles below:
- During tightening cycles, US 10-yr was between 3.5% to 5.5%
- Nov 1954 to Oct 1957
- July 1958 to Nov 1959
- Dec 1965 to Nov 1966
- June 1999 to July 2000 (dotcom)
- You get the picture
- This is not “selective history”
NARROW RANGE: But look at how narrow the P/E range is during UST at 3.5% to 4.5%
Cleaning up the charts, we only wanted to look at the distribution range of P/E by:
- excluding top 20% and bottom 20%, thus, only looking at middle 60%
- look at how narrow the P/E range is for interest rates around here (shaded)
- P/E median is 18.5X with a small range
- None of the plots are 15X P/E
- This is what is important to keep in mind
REAL RETURNS: S&P 500 is down nearly 30% in “real terms” (CPI adjusted) in 2022… Fed won
The Fed wanted to tighten financial conditions in 2022. And this is transmitted by causing asset prices to fall. Take a look at YTD returns of various household assets in 2022.
- the Fed won
- everything is down
- focus on the YTD returns in “real terms” as inflation is a factor
And with the snowballing declines in home prices (Case Shiller only shows August), this is a sign that the earlier tightening is already having a strong effect.
Since August:
- Fed raised another +75bp
- Housing indicators show far worse slowing
Multiple economists, including Paul McCulley, formerly of PIMCO, noted similarly. That in real terms, a rally in equities does not unwind the Fed’s efforts. Financial conditions have already tightened dramatically.
REAL RETURN: If S&P 500 rallies back to 4,400…Fed wins as real returns -16%
This gets us to the notion of a rally in equities. While many cite Fed as pushing back on stocks recovering. Take a look below:
- S&P 500 is down -30%-ish in real terms (adjusted for inflation)
- If S&P 500 rallies to 4,400 to 4,600 in the near term
- This is still down -12% to -16% in real terms
- That is a dramatic wealth effect loss and tightening of financial conditions
CROSS MARKET: Yields, USD and VIX also improving
Many supporting factors also came into play Tuesday.
- yields finally are easing although UST 10-yr still above 4% and 2-yr still near 4.5% — so good, but could be better
- USD has finally eased in a more sustained way but still higher for month of October
- VIX moved below 30 and this should allay concerns
Ingredients for a rally that should exceed the “June pivot” rally in duration and amplitude
All of this, in our view, are reasons that any equity rally should exceed that seen in July, which was the “false dawn of a Fed pivot”:
- that rally was 23 trading days and gained +16%
- at that time, only headline CPI peaked and many investors expected core CPI to keep strengthening
- labor markets were extremely tight in July with JOLTS/workers ~2.0
- that ratio is 1.67 today and falling
- more economists now forecast substantial declines in core CPI ahead and we highlight JPMorgan’s report below
- today, multiple Fed members are openly discussing some type of “pause and look around” which is a dovish turn
- investor positioning is far more bearish now than anytime in 2022
Taken together:
- doesn’t it make sense a rally should exceed the “false dawn pivot”?
- consider a possible 30-50 day rally and 20-25%?
- 2022 mid-terms will be in the coming weeks, and our Policy Strategist, Tom Block, believes Republicans will take the House and even possibly the Senate
- This would be considered disinflationary as well (reign spending) driving possibly lower rates
- And voters likely see less risk of “higher inflation” (with Republicans) and thus, reduce the risk of a wage-price spiral
- The fly in the ointment, however, is the continued surge in 10-yr yields
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SKIP TUESDAY
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Friday
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